Narrowing bond yields signal liquidity squeeze in markets, shows data

Spread between 10-yr G-sec and 2-yr bond yields narrows to 38-mth low

Financial markets are signalling liquidity tightening and a slowdown in the economy, as shown by a sharp rise in yields on short-term bonds, resulting in the spread between those and the rates on long-term bonds narrowing.

The spread between the yield on the 10-year government of India and two-year bonds declined to a 38-month low of 36 basis points on Tuesday compared to 83 basis points at the close of last month and 200 basis points at the end of December last year.

The spread was 209 basis points at the end of August last year.

According to the data from Clearing Corporation of India (CCIL), the yield spread between the shortest-tenure (91 days) and the longest-tenure (40 years) bonds declined to 197 basis points on Tuesday from 260 basis points at the end of August and 341 basis points at the end of December last year.

One basis point is one-hundredth of a percentage point.

The result has been the zero-coupon yield curve flattening, which signals deterioration in liquidity conditions and a growth slowdown in the economy in the coming months.

“Liquidity has tightened in the financial market in the last few days with a sharp decline in the surplus available with the Reserve Bank of India. This is forcing borrowers to pay higher interest (or yield) to raise money by issuing short-term instruments,” said Madan Sabnavis, chief economist, Bank of Baroda.

He expects this to reverse in the next two weeks.

The decline in liquidity has been attributed to factors such as reduction in foreign exchange reserves, advance tax payments by companies, and much faster growth in bank credit than in deposits.

The yield on the two-year government of India bond rose to 6.91 per cent on Tuesday, up 55 basis points from the 6.36 per cent at the end of August.

The yield on the one-year government of India bond closed on Tuesday at 6.53 per cent, up 33 basis points from the 6.20 per cent at the end of August.

Much of the rise in yields on short-tenure bonds took place in the last eight trading days.

In contrast, the 10-year bond market has been fairly stable during the month so far and it was trading with a yield of 7.26 per cent on Tuesday, up seven basis points from the 7.19 per cent at the end of August.

“The yield curve flattening means businesses are largely doing short-term borrowing for working capital and there is little demand for long-term projects loans. This hints at slower economic growth in the second half of FY23,” said Dhananjay Sinha, head of research and chief strategist, Systematix Group.

Bond yields are India following developments in the United States, where the yield curve is inverted at a three-month now.

Yields on short-term bonds in the US are now higher than those on long-term bonds, which is most often the case in normal economic conditions. The yield on the two-year US government bond is now 3.97 per cent while the 10-year US government bond yields 3.54 per cent.

This inversion has been accompanied with a slowdown in GDP growth in the US and a high probability of a recession later this year or the first half of CY23.